The impossible trinity, or the trilemma, refers to the idea that an economy cannot pursue independent monetary policy, maintain a fixed exchange rate, and allow the free flow of capital across its borders at the same time.
According to economists, any economy can choose to pursue only two out of the three policy options noted above simultaneously in the long-run.
The idea was proposed independently by Canadian economist Robert Mundell and British economist Marcus Fleming in the early 1960s.
A difficult choice
Practically speaking, in today’s world in which capital is largely free to move across borders with ease, the choice before policymakers is between maintaining a fixed exchange rate and pursuing independent monetary policy.
If policymakers choose to peg or maintain the value of their currency at a certain level against a foreign currency, this decision will limit the kind of monetary policy they can adopt in the long-run.
This is because the decision to peg the exchange value of the currency can tie down the hands of central bankers when it comes to their domestic monetary policy stance.
For example, if a country’s policymakers want their currency to appreciate, or become stronger, against foreign currencies, they cannot achieve this goal and maintain the external strength of the currency over a considerable period of time without adopting a tight domestic monetary policy stance which will weaken domestic demand.
This is because loose monetary policy will put pressure on the country’s currency to depreciate in value. Thus, policymakers will have to choose between maintaining the strength of their currency and upholding nominal demand in the domestic economy which is heavily influenced by monetary policy.
On the other hand, if policymakers of a country choose to pursue independent monetary policy, they may not be able to maintain the foreign exchange value of their currency at a desired peg.
This is because the kind of monetary policy adopted by an economy’s central bank invariably influences the exchange value of its currency against foreign currencies.
For example, if a country’s central bank adopts easy monetary policy with the aim of boosting domestic demand, this will naturally cause the value of its currency to depreciate against foreign currencies if foreign central banks adopt tighter monetary policy.
If so, it would be difficult to maintain the foreign exchange value of the currency unless the central bank holds sufficient foreign exchange reserves to prop up the currency’s value.
In fact, over the long-run, it may be impossible for the country’s central bank to defend the foreign exchange value of its currency as it may soon run out of the foreign exchange reserves necessary to prop up the value of its currency.
It should be noted that only a few decades ago, when strict capital controls were used to regulate the flow of capital across borders, economies could choose to pursue independent monetary policy and still hope to maintain a certain exchange value against foreign currencies.
Whenever monetary policy exerted an undesirable effect on the currency’s exchange rate, policymakers could impose controls on the flow of capital to maintain the foreign exchange value of their currency.
For example, if a country’s central bank decides that it wants to adopt easy monetary policy that could weaken the exchange value of its currency, it could impose capital controls to stop the depreciation of its currency. It should be noted, however, that capital controls come at a price. They hinder the free flow of capital and adversely affect economic growth by preventing the efficient allocation of scarce resources across the globe.
The trilemma has come under focus recently as the U.S. Federal Reserve has been raising interest rates to fight rising prices.
In a world where capital is largely free to move across borders, this has led many investors to pull money out of the rest of the world and rush to the U.S. in search of higher yields, thus putting pressure on many currencies such as the Indian rupee.
In fact, even developed markets like Japan and the Eurozone have seen their currencies depreciate significantly against the U.S. dollar.
Notably Japan, in contrast to other national central banks, has been unwilling to tighten its monetary policy in response to rising interest rates in the U.S.
This has caused the Japanese currency, the Yen, to depreciate about 25% against the U.S. dollar so far this year.
In essence, the Bank of Japan has allowed its currency to fall, preferring to maintain control over its domestic monetary policy.
The Reserve Bank of India may also face the dilemma of choosing between maintaining the value of the rupee and holding on to its monetary policy independence.
As the U.S. Federal Reserve has raised interest rates, there has been increasing pressure on the rupee, which has depreciated almost 10% against the U.S. dollar this year.
For now, the RBI seems to be fairly happy tightening its monetary policy stance to defend the rupee as it also helps to rein in price rise which has been a concern even in India.
But if the U.S. Federal Reserve continues to tighten its policy stance even after price rise in India is reined in by the RBI, then the Indian central bank may have to choose between defending the rupee and upholding domestic demand.